BofA’s autocallable step-up notes linked to PHLX Housing offer two chances to beat market

By Emma Trincal

New York, Oct. 4 – Bank of America Corp.’s autocallable market-linked step-up notes due October 2018 linked to the PHLX Housing Sector index give mildly bullish investors two opportunities to outperform the housing sector in a slow growth environment.

But investors need to have some level of conviction as the notes offer no downside protection, sources said.

The first chance to outperform the sector index is if the notes are automatically called on an observation date in October 2017. If on that day the index closes at or above the initial level, the notes will be called at par of $10 plus a call premium of 9%, according to an FWP filing with the Securities and Exchange Commission.

The second opportunity in the absence of a call is at maturity. If then the index finishes below the step-up value, 117% to 123% of the initial level, but at or above the initial level, the payout will be par plus the step-up return of 17% to 23%.

The payout will be the index return if the index finishes at or above the step-up value or if it finishes below the initial level.

Alpha

“This is for an investor who is mildly bullish on the index,” said Tom Balcom, founder of 1650 Wealth Management.

“It’s a sector bet on the housing industry. It’s not without risk because this is a very interest-rate-sensitive industry.

“But if the index continues to perform as it has over the past year or so, the note can really offer a nice opportunity to outperform.”

The index tracks companies that work in the U.S. construction market with a majority of builders.

It has underperformed the market this year with a 4.45% gain versus 5.20% for the S&P 500 index.

“If the sector performance is just flat, you get maybe 20% after two years. That’s a 10% digital coupon ... much better than 4% or 5% a year.”

Risk

Naturally, any return enhancement feature in a note comes with risk, he said.

“A significant headwind would be rising interest rates. If rates go up, it would be more difficult to refinance or purchase a home, and that would be a negative for builders,” he said.

“You can make 9% after one year, but if you’re not called, you can lose a lot of money a year later. So risk is obviously a concern.”

The index, which is concentrated in one sector with only 19 components, has displayed wide price swings over the past two years. From a low in October 2014, the index soared nearly 40% to a peak at the end of July this year. In the past two and a half months, the PHLX Housing sector index has shed nearly 6%.

For Balcom, the deal might be appropriate for investors who have “return goals,” while it might not be a good option for conservative investors.

“I don’t have a particular view on the housing sector. Personally I always prefer a protection built in. I would be concerned with interest rates. At the same time, I know that you can’t get this type of return if you have the downside protection.

“If you stretch for more upside, you have to give up on the downside. You can’t have it both ways.

“You have to weigh which part you want the most.”

Bulls and bears out

Donald McCoy, financial adviser at Planners Financial Services, said that the notes would “eliminate” a wide range of potential investors because bears and bulls would not be investing in the product.

“This is for someone who thinks this market will do OK but not great,” he said.

Bulls would have no appetite for it.

“You get the autocall, and if you’re not called, you get the index minus dividends. Why would I cap myself, and why would I give away the dividends if I’m bullish?” he said.

“If you’re bearish, you wouldn’t get into it, especially if there’s no buffer or barrier.”

While the potential return of 9% after one year or the step-up return at maturity are significant, McCoy wondered who might benefit from the autocall and step-up features most.

“It’s such a narrow view. You have to think the index will be somewhat flat and that it won’t go down. How many people will be willing to take that bet?” he said.

Volatility has to be considered.

“It’s a range-bound bet, so volatility is key. You are basically betting that it will trade between zero and the step, and you are penalized if it breaks out of the range.”

Niche

He said investors face three adverse events: a call premium that may cap their return below the market price, the loss of dividends if the index finishes above the step level and the full downside exposure to price declines.

“This product seems like a niche to me. I’m not sure you could get clients to be very excited about it,” he said.

“You have to talk about the specific sector. Is the client comfortable with it? It seems like a fairly concentrated index to me. The top three stocks are already more than a third of the index.”

The top three holdings – Weyerhaeuser Co., Vulcan Materials Co. and Masco Corp. – represent a third of the index.

Protection wanted

“You’re really betting on getting the premium or the step-up,” he said.

But the risk far outweighs the chances of benefiting from those two return enhancement features, he said.

“Given the high valuations we’re in right now, there’s a high probability that the index will be down in one or two years.”

Investors have recently become more cautious, less optimistic, he noted. As a result, they tend to shy away from unprotected notes.

“Most people invest in structured notes for the downside protection, not for any kind of market boost,” he said.

“If you’re looking for market exposure, you can get it on your own without sacrificing the dividends and the liquidity.”

BofA Merrill Lynch is the agent.

The exact deal terms will be set at pricing.

The notes will price in October and settle in November.

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